In a previous Client Alert, I analyzed six published SEC enforcement cases I found naming independent directors1 of an investment company as respondents. Of those six cases, five resulted in the SEC finding that an independent director violated federal securities laws and, of those five, four involved misvalued securities. Based on this analysis, I concluded that misvalued securities represent the greatest enforcement risk for independent directors, particularly for directors of small, stand-alone investment companies and for directors of investment companies with large, fixed-income holdings.
Directors’ legal responsibilities for valuing portfolio securities is a logical place to start an examination of why misvalued securities pose a risk to independent directors. This Client Alert therefore considers the definition of "value" in the Investment Company Act of 1940 (the “1940 Act”), and highlights some shortcomings of this definition by comparing it with the more modern approach to defining “fair value” in financial reports.
1. "Value" under the 1940 Act
Section 2(a)(32) of the 1940 Act defines a "redeemable security" as "security, …, under the terms of which the holder, upon its presentation to the issuer …, is entitled (whether absolutely or only out of surplus) to receive approximately his proportionate share of the issuer's current net assets, or the cash equivalent thereof."2 Rule 2a 4 defines "[t]he current net asset value of any redeemable security issued by a registered investment company …." With respect to portfolio securities, Rule 2a 4 incorporates the definition of "value" provided in section 2(a)(41)(B) of the 1940 Act:
(i) with respect to securities for which market quotations are readily available, the market value of such securities; and
(ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors.
Under section 404.03.b.ii of the SEC’s Codification of Financial Reporting Policies, a "market quotation" means either (a) "[i]f a security is traded on the valuation date, the last quoted sale price" or (b) if the security is not traded on the valuation date, a value in the range of "published closing bid and asked prices." Such "published" prices are the prices at which a broker has offered to purchase (a "bid price") or sell (an "asked price") the security up to some specified amount. If multiple brokers make a market in the security, the published prices may reflect the highest bid and lowest asked-price available, even if the prices are from different brokers, or an average of the bid and asked-prices available, so long as the fund values the security below its asked price.
With respect to "fair values," the SEC has provided the following guidance:
As a general principle, the current "fair value" of an issue of securities being valued by the board of directors would appear to be the amount which the owner might reasonably expect to receive for them upon their current sale.3
The 1940 Act’s definition of "value" imposes a strict dichotomy: if a market quotation is readily available, it must be used to value a portfolio security; otherwise, the board of directors must determine the security’s fair value. The SEC has given investment companies some leeway, however, in deciding when a market quotation is "readily available." According to the SEC:
If the validity of the quotations appears to be questionable, or if the number of quotations is such as to indicate that there is a thin market in the security, further consideration should be given to whether "market quotations are readily available." If it is decided that they are not readily available, the security should be considered one required to be valued at "fair value as determined in good faith by the board of directors."4
This guidance uses the term "readily available" to recognize that there may be differences in the quality of market quotations. Not all transactions may represent equally reliable indications of value. For example, if numerous stores offer an item at the same price, and thousands of customers pay that price for the item every day, the price should be a reliable indication of the item’s retail value. On the other hand, a single transaction over E-Bay™ unloading a used knick-knack does not mean that anyone else could sell the item for the same price. A similar question of reliability may arise if only a few investors trade a security on an infrequent basis, so that the market for the security is "thin" rather than "deep."
To summarize, under the 1940 Act, the board of directors must determine, in good faith, the fair value of every portfolio security for which a market quotation is not readily available. A market quotation is readily available if, on the date of valuation:
The portfolio security was traded on that date; or
Bid and asked prices for the portfolio security are being published by brokers; and
The number of trades and published quotations do not indicate that there is a thin market for the portfolio, and circumstances do not otherwise bring the validity of the trades or quotations into question.
Subject to this last condition, on any day that a portfolio security trades, its last sale price is its market quotation; otherwise, its market quotation must be a published bid price or a value in the range of published bid and asked prices.
2. The Fair Valuation Hierarchy under Accounting Standards Codification 820
FASB’s Accounting Standards Codification 820 ("ASC 820," which was originally adopted as Financial Accounting Standard 157 (FAS 157) in 2006) provides an instructive contrast to the 1940 Act’s definition of "value." Although I am not an accountant, my superficial understanding of ASC 820 should be sufficient to illustrate some important differences from the 1940 Act’s approach to portfolio valuation.
ASC 820 governs how the fair value of assets5 should be determined for purposes of financial reporting. ASC 820 defines "fair value" as "the price that would be received to sell an asset … in an orderly transaction between market participants at the measurement date."6 It groups the techniques used to determine fair value under three general headings:
Market approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets ….7
Cost approach. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset ….8
Income approach. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted).9
The cost approach rarely applies to the valuation of securities.
ASC 820 also differentiates between the inputs used to determine an asset’s fair value, based on whether the inputs are "observable" or "unobservable."
[Observable] Inputs … are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset ….
[Unobservable Inputs are] inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset ….10
Finally, ASC 820 creates a "fair value hierarchy" based on the inputs used to determine a fair value.
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets … that the reporting entity can access at the measurement date.11
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset …, either directly or indirectly.12
Level 3 inputs are unobservable inputs for the asset ….13
"The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets … (Level 1) and the lowest priority to unobservable inputs (Level 3)."14 Examples of Level 2 inputs include yield curves, implied volatilities, credit spreads and inputs "derived principally from or corroborated by observable market data by correlation or other means."15 Level 3 inputs may be based on "the reporting entity’s own data," although the data must be adjusted "if reasonably available information indicates that other market participants would use different data …."16
ASC 820 requires escalating levels of disclosure for each level in the fair value hierarchy.17 First, the reporting entity must disclose the level of inputs used for its fair value measurements.
Second, the entity must disclose any transfers of assets between Levels 1 and 2. For Level 2 and 3 assets, the disclosure must provide "a description of the valuation technique(s) and inputs used …. If there has been a change in valuation technique … the reporting entity [must] disclose that change and the reason(s) for making it." Level 3 fair value measures also require "quantitative information about the significant unobservable inputs used." The reporting entity must reconcile opening and closing balances of Level 3 assets for the period and disclose the impact of changes in the fair value of such assets on financial results for the period.
To summarize, under ASC 820, the directors are no more responsible for the valuation of assets than they are for the other information included in their company’s financial reports. A market quotation (Level 1) is the preferred basis for an asset’s fair value, but only if there is an active market for the asset and a market quotation is assessable as of the time of valuation. Otherwise, the fair value should be based on observable market information (Level 2) or, failing that, unobservable information (Level 3). Valuation techniques and inputs must be disclosed for Level 2 and 3 assets, together with information regarding the impact of changes in Level 3 fair values on the company’s financial results.
3. Comparison of the 1940 Act Definition of "Value" and ASC 820
(a) Common Elements
ASC 820 and the definition of "value" in section 2(a)(41)(B) have a good deal in common. Both include concepts of a "market quotation" and of "fair value." Both give priority to valuations based on market quotations, but only to the extent market quotations are available. The SEC’s definition of "fair value" is substantially the same as ASC 820’s definition. Finally, ASC 820’s requirement that market quotations come from "active markets" corresponds to the SEC’s warning that market quotations for "thinly traded" securities may be unreliable.
(b) Fundamental Differences
From a mutual fund director’s perspective, the most important difference between the 1940 Act and ASC 820 is that ASC 820 never requires the directors to determine the fair value of an asset. Under ASC 820, fair value measurements are subject to the same procedures, controls and audit committee oversight as other elements of a company’s financial reports.
Another fundamental difference between the two approaches relates to the significance of market quotations. The 1940 Act creates a dichotomy between market values and fair values, treating them as exclusive alternatives. In contrast, ASC 820 treats all valuations as "fair values." Market quotations are but one of several inputs on which a fair value may be based. ASC 820 recognizes that, regardless of the techniques and inputs used, "fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset …."18
By classifying market quotations as observable inputs, ASC 820 treats them as evidence of the potential "exit price" for a security, rather than as an absolute standard of "market value." A lawyer might say that, under ASC 820, market quotations provide the "best evidence" of fair value, which is why market quotations are elevated to Level 1. Contrary evidence from other observable inputs may rebut market quotations, however. ASC 820 lists eight circumstances in which inputs in addition to market quotations may be appropriate for determining an asset’s fair value, including, for example, when "[p]rice quotations vary substantially either over time or among market makers …."19
Finally, ASC 820 recognizes that fair values based on unobservable inputs create a greater potential for conflicts of interest than values based on observable inputs. ASC 820 requires additional reporting for Level 3 values and their impact on financial results to facilitate monitoring of potential conflicts. The 1940 Act, in contrast, tasks directors with determination of all fair values, regardless of the potential for conflicts of interest.
4. Implications for Independent Directors
Given a choice between the 1940 Act’s definition of "value" and the approach to valuation taken in ASC 820, independent directors should prefer ASC 820. First and foremost, ASC 820 does not directly involve directors in the valuation process; it treats valuation as just another aspect of financial reporting. We will leave for a future Client Alert the discussion of whether mutual funds warrant a heightened level of director involvement in calculating their net assets.
Second, ASC 820 does not draw an arbitrary distinction between market value and fair value. The literal terms of section 2(a)(41)(B) require the use of market quotations whenever available, leaving the directors without apparent discretion to use a different method of valuation. ASC 820 treats market quotations as the best, but not the exclusive, basis for determining a fair value. ASC 820’s view of market quotations makes it easier to understand why, for example, it may be appropriate to override market quotations from foreign stock exchanges in response to significant events that occurred after the exchanges closed for trading.
SEC guidance on thinly traded securities and other potentially unreliable market quotations have relaxed the 1940 Act’s mandate to use market quotations. The guidance leaves open, however, the question of who should determine when a market quotation becomes "unreliable."20 The guidance is also less detailed than ASC 820 in describing the circumstances in which market quotations may not be the best evidence of fair value. Thus, the SEC’s guidance arguably makes the directors’ valuation responsibilities more ambiguous.
Another consequence of the 1940 Act’s dichotomy is that fair value becomes the catch-all for any security without a market quotation. This makes the directors responsible for every conceivable alternative valuation methodology. Finance theory has developed a wide array of valuation methodologies since 1940. The 1940 Act did not anticipate these developments, and thus has tasked directors with overseeing increasingly complex methodologies.
In contrast, ASC 820 differentiates among valuation techniques and their inputs. In particular, it recognizes distinctions between market-based and income-based methodologies, and between observable and unobservable inputs. These distinctions could be used to regulate the directors’ involvement in the valuation process. For example, market-based valuations based on observable inputs probably require little, if any, involvement by the board of directors.
Finally, the disclosure requirements of ASC 820 illustrate the utility of molding the valuation process to correspond to potential conflicts of interest. By requiring directors to determine every fair value, regardless of methodology, the 1940 Act effectively presumes that every fair value carries the same potential for conflict of interest. ASC 820, on the other hand, recognizes that the potential for conflicts of interest are more significant for a fair value based on unobservable inputs, and heightens its disclosure requirements accordingly. It would be beneficial if mutual fund directors could prioritize their involvement in the valuation process in a similar fashion, by requiring the most detailed information and external review for valuations most at risk of undue influence from the fund’s advisor or other affiliated persons.
Having considered the law of valuation, the next Client Alert will delve into the facts: namely, why market quotations are normally "readily available" for equity securities but not for fixed income securities.
As used in this Client Alert, an "independent director" is a director or trustee of an investment company registered with the SEC who is not an "interested person" as defined in section 2(a)(19).
Although closed-end investment companies do not issue redeemable securities, they must report their current net asset value in accordance with the same definition of "value." See, Codification of Financial Reporting Policies Section 404.03.b.i.
Codification of Financial Reporting Policies Section 404.03.b.iv.
Codification of Financial Reporting Policies Section 404.03.b.iii. This comment may have originally been limited to securities not listed on an exchange. The SEC staff has applied this exception more generally, however. See, infra, note 20.
ASC 820 also applies to the fair valuation of liabilities, which is not relevant to this discussion. References to liabilities have been elided from the quoted provisions of ASC 820.
ASC 820-10-20 (definition of “Market-Corroborated Inputs”) and -10-35-48.
The SEC’s staff has stated its view that "funds should assess the availability of market quotations for their portfolio securities each day by reviewing various factors, including whether the securities are thinly traded, sales have been infrequent, or other data exist that may call into question the reliability of the market quotations. [Footnote omitted] Funds that automatically use market quotations to calculate their NAVs, without first verifying that the market quotations are readily available, cannot be assured that the resulting NAVs are accurate." Inv. Co. Inst., SEC Interpretive Letter, WSB File No. 0430200107 (pub. avail. Apr. 30, 2001).